If you are in the finance world for years, chances are you have heard of the free cash flow to firm, or simply FCFF. Maybe you need to calculate it frequently. As you may already know, it plays an important role in valuing a company. That can come in handy when you want to perform an analysis regarding discounted cash flow.
The good news is that we have created the FCFF calculator that will help you calculate this metric quickly. Read on to learn how to use this calculator and find out more about the free cash flow to firm. This article covers everything from the FCFF definition to the FCFF formula and the FCFF valuation method. It is worth reading!
What is Free Cash Flow to Firm (FCFF)?
Are you new to investing? If so, you need to have a basic understanding of free cash flow. That’s why we will explain it briefly before moving on.
In a nutshell, free cash flow (FCF) is a firm’s cash that is generated by all of its operations without the cost of capital expenditures. The free cash flow is also known as operating cash flow, or operating profit after tax minus capital expenditure and investment.
FCF is the amount of cash that a company generates from its operations. In other words, it is a measure of how much money a business makes after it pays for all its expenses. It is important to note that free cash flow is not impacted by the company’s capital expenditures and investments. This measure is often used when determining the value of companies.
Definition of FCFF
Now that you are familiar with free cash flow, it is time to explain FCFF and see how it can be defined. It is the cash flow of a company that can be distributed to every funding provider (whether it is debt or equity holder) once all the expenses and reinvestments are paid. So, unlike FCFE, the cash flow is used by funding providers instead of equity holders.
Another thing that makes the difference is that this valuation model is used to determine the value of the entire firm or company, while FCFE concentrates solely on the equity value. They are both useful metrics for evaluating the share price of the company.
It is important to note that the capital contributed by a company’s equity and debt holders makes up a certain part of its assets. That being said, the free cash flow to firm plays a vital role in valuing the company. This valuation technique is often used in the DCF (discounted cash flow) analysis. Keep reading to learn how the FCFF formula is used.
FCFF Formula: How to Calculate Free Cash Flow to Firm?
Let’s explain the FCFF formula and its elements. Keep in mind that the free cash flow to firm can be calculated in a few different ways. For example, it can be derived from:
- Net income using this formula: FCFF = NI + D&A + IE * (1 – CIT) – FCI – NWC
- Earnings before interest and taxes (EBIT). The formula is: FCFF = EBIT * (1 – CIT) + D&A – FCI – NWC
- EBITDA (earnings before interest, taxes, depreciation, and amortization). The formula is: FCFF = EBITDA * (1 – CIT) + D&A * CIT – FCI – NWC
- Cash flow from operation (CFO): FCFF = CFO + IE * (1 – CIT) – FCI
We will focus on the first method that involves calculating FCFF from the net income. By the way, our FCFF calculator uses this method. Below is the formula:FCFF = NI + D&A + IE * (1 – CIT) – FCI – NWC
Where:
- NI is net income. Net Income is a key metric of profitability. It is calculated by subtracting the cost of revenue from the gross profit. The net income is calculated by subtracting the total revenue from total costs and then dividing that amount by the total revenue. It can be calculated as follows: Total Revenue – Total Costs = Net Income
- D&A stands for depreciation and amortization. Depreciation is the process of allocating the cost of a fixed asset over its useful life. Amortization is the process of allocating the cost of a financial asset, such as a loan, over time. Depreciation and amortization are important because they allow you to deduct some or all of an asset’s value from your taxable income.
- IE means interest expense. Interest expense is an accounting term that measures the cost of borrowing money. It is calculated by taking the interest paid or accrued during a period and dividing it by the average outstanding balance for that period. The interest expense from borrowed money can be an operating expense, or it can be classified as investment expenditure depending on how the borrowed funds are used.
- CIT stands for corporate tax rate. The corporate tax rate is the percentage of profits that a company will be taxed. The tax rate is determined by the country in which the company is incorporated and operates. There are three types of corporate taxes, including income tax, capital gains tax, and corporate income tax.
- FCI means fixed capital investment. It is the sum of investments in fixed assets, such as buildings and machinery. This is one of the most important components of aggregate demand and economic growth.
- NWC is a working capital investment (it is also known as net working capital). Working capital is the money a company needs to operate its business. This includes the funds needed to meet short-term obligations and maintain liquidity.
Example
Now that you know what each element of the FCFF formula means, let’s see how the FCFF formula is used in finance.
- Net Income: $5,600,000
- Depreciation and Amortization: $5,000,000
- Interest Expense: $1,500,000
- Corporate Tax Rate: 30.00%
- Fixed Capital Investment: $10,000,000
- Working Capital Investment: $2,500,000
FCFF = NI + D&A + IE * (1 – CIT) – FCI – NWC
FCFF = 5,600,000 +5,000,000 + 1,500,000 * (1 – 0.30) – 10,000,000 – 2,500,000
FCFF = -850,000
In our example, the FCFF is negative. This means the operations of the company don’t generate cash, but they give rise to the dept by costing the investors money. As you can see, this computation is a bit complex and it takes a while to calculate the free cash flow to firm. That’s why you should use the FCFF calculator to save time.